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U Bear Market Investing Strategies

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U Bear Market Investing Strategies

  1. 1. Bear Market Investing Strategies
  2. 2. WILEY TRADING SERIES The Psychology of Finance, revised edition Lars Tvede The Elliott Wave Principle: Key to Market Behavior Robert R. Prechter International Commodity Trading ´ ´ Ephraim Clark, Jean-Baptiste Lesourd and Rene Thieblemont Dynamic Technical Analysis Philippe Cahen Encyclopedia of Chart Patterns Thomas N. Bulkowski Integrated Technical Analysis Ian Copsey Financial Markets Tick by Tick: Insights in Financial Markets Microstructure Pierre Lequeux Technical Market Indicators: Analysis and Performance Richard J. Bauer and Julie R. Dahlquist Trading to Win: The Psychology of Mastering the Markets Ari Kiev Pricing Convertible Bonds Kevin Connolly At the Crest of the Tidal Wave: A Forecast for the Great Bear Market Robert R. Prechter
  4. 4. Copyright # 2002 by John Wiley & Sons Ltd Baffins Lane, Chichester, West Sussex PO19 1UD, England National 01243 779777 International (þ44) 1243 779777 e-mail (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on http://www.wiley.co.uk or http://www.wiley.com All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE, UK without the permission in writing of the publisher. Other Wiley Editorial Offices John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, USA Wiley-VCH GmbH, Pappelallee 3, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons (Canada) Ltd, 22 Worcester Road, Rexdale, Ontario M9W 1L1, Canada Library of Congress Cataloging-in-Publication Data A Library of Congress record has been applied for British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0-470-84702-6 Project management by Originator, Gt Yarmouth (typeset in 10/12pt Times) Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall This book is printed on acid-free paper responsibly manufactured from sustainable forestry, in which at least two trees are planted for each one used for paper production.
  5. 5. Contents 1 Introduction 1 Part I THE BEAR BACKGROUND 7 2 Overview 9 3 History of Bear Markets 17 Part II ECONOMIC SETTING FOR BEAR MARKETS 29 4 Guideposts for Bear Markets 31 5 Globalization, Terrorism, and Foreign Investment 39 Part III STRUCTURE OF BEAR MARKETS 43 6 Secondary Reactions 45 7 Bear Market Legs 52 Part IV TOOLS FOR MEASURING BEAR MARKETS 57 8 Tools to Help You Recognize and Survive a Bear Market 59 9 Tools that ‘‘Change Shape’’ in Bear Markets 74 10 Cycles Study: A Useful Market Tool? 78 11 Chart Reading and Interpretation 83 Part V MONEY-MAKING TACTICS 89 12 Preservation of Capital during a Bear Market 91 13 Short Selling 101 98 14 Strategies for Making Money Even If You Guess Wrong 108 15 Rules for Being a Flexible Investor 115 16 Defensive Investments that Allow You to Sleep Nights 119
  6. 6. vi Contents Part VI THE EMOTIONAL ASPECT 127 17 Human Psychology in the Marketplace 129 18 Contrary Opinion 137 Part VII PREDICTIONS AND CONCLUSIONS 143 19 The Past is Prologue 145 20 Epilogue 155 Glossary of Terms and Tactics for Market Mastery 159 Resources/Recommended books, newsletters, data suppliers, 168 chart services Index 175
  7. 7. 1 Introduction ‘‘History never looks like history when you are living through it. It always looks confusing and messy, and it always feels uncomfortable.’’ John W. Gardner, 1968 Over the last 20 years, investors have increasingly come to regard investing in stocks about the same as putting money in the bank—except they got a higher return. This belief became so pervasive that, as recently as 2000, the govern- ment in Washington was still talking about putting part of the Social Security account into securities in order to earn a higher return. After the Nasdaq crash, that plan was quietly dropped. Even investors who researched stocks before buying them either mostly used computer programs that rely on past action repeating more or less exactly in order to predict future buy or sell points, or they used Internet advice which in many cases was nothing more than thinly disguised sales pitches. There is an old adage which says that knowledge can be communicated but wisdom has to be self-taught. I hope that, by the end of this book, you will have enough knowledge to evolve your own market wisdom. With the coming of the Internet, investors were so focused on acquiring the latest information on securities that many never bothered to learn how that information could be best used. And just as many of us have lost the ability to spell correctly or do simple arithmetic because we rely on spell checks and computer calculators, so investors who rely only on the Internet for investment know-how have never had to learn the basic signals to judge where markets will go next. Even more dangerous is the assumption that prediction is a scientific process, whereby if
  8. 8. 2 Bear Market Investing Strategies you have the right piece of software that correctly predicted market turning points in the recent past, it would certainly be able to predict the future. But market analysis is not a science; it is an art, using intuition and experi- ence to make sense of evolving data. Past patterns may at times not have their usual relevance for future predictions. I have been writing an investment newsletter for 38 years, and I seem to be on virtually every investment mailing list there is. During the last 5 years of the 1990s, I was inundated with junk mail from software companies claiming to have the key to future market success, based only on their program having called turning points for a few prior years. These software packages used such phrases as: ‘‘fully automated trading software,’’ and ‘‘built-in portfolio,’’ implying that all you needed to make money in the stock market was knowledge of how to operate their software. Until the mid-1990s, analysts on financial news programs did useful research and offered informed opinions of where markets in general and specific stocks were likely to go. But increasingly over the subsequent years those same analysts concentrated ever more on being entertainers, as all business news programs became little more than infomercials for their advertisers. The focus became less to seriously inform and more on keeping the viewer watching so the advertisers would have an audience. But then markets topped out, Nasdaq crashed, and the war on terrorism gave the media permission to use the word ‘‘recession,’’ without being accused of ‘‘talking down the market.’’ Investors were left wondering what to do with stocks that in many cases had already lost a substantial portion of their value in the prior 2 years. Their ‘‘magic bullet’’ software programs failed them, and they lacked basic market know-how, or how to invest in what appears to be the early stages of a protracted bear market. This book is designed to upgrade investors’ knowledge with the basics of how to make investment decisions, with particular reference to bear markets, bull market corrections and recessions. But simply knowing how to make respectable buy and sell decisions is not enough. Nobody in the history of Wall Street has ever guessed right all the time. It’s therefore necessary not only to decide how to predict market direction, but what strategies to use to minimize losses when you guess wrong, and maximize your profits when you are right. The ultimate decision for your investments is made by you. Over the nearly 4 decades I have been advising clients, there have been many times when I would give the same advice to three people, and one would make money, one would break even, and one would lose money. However good the advice we receive, we always inject our own judgment into the equation. In this book, we will discuss how best to make your own informed decisions. A key principle of technical analysis is that there are certain recurring
  9. 9. Introduction 3 patterns of investing behavior that can be charted. But no technical tool works all the time. Though history does seem to repeat itself in a general sense, it never repeats exactly, so no one model of past action, be it a war, inflation, civil unrest, or a bear market, is sufficient to ascertain what the future will bring. After the September 11, 2001 attack on New York and the Pentagon, advisors rushed to predict future markets, based on what the Dow Jones Averages did in the Gulf War, or the Vietnam War. But the war on terrorism is unlike any war in the past. The recession of 2000 seems likely to have variations from a number of past recessions. The best way to use the past for future projections is to have as much history as possible of past events: market averages, individual stock groups, technical indicators such as Confidence Index or advance/decline lines, wars, govern- ment monetary intervention, etc. Then check for similarities to what is happening today. With this data, we can then build a mental big picture for possible future market direction based on elements of as much history as possible, which taken together form a totally new paradigm. This book discusses past models based on technical analysis and chart reading, plus similar economic, political, war, and social conditions. Hopefully, by the end of this book, you will have enough information to construct your own market vision for the next several years. A WARNING Any composite model view of possible future action is never static. As events change and unfold, your predictive model should be modified. This book is written at a specific point in time. Even if the visions I offer in the later chapters are correct in a general sense, I cannot possibly be correct about the details. It is up to you to update and fine-tune your model as things evolve. WHAT YOU WILL LEARN This book offers both the novice and the seasoned investor perspectives on investment theory and strategies, with particular reference to recessionary times. Chapter 2 defines exactly what a bear market is and how it is different from corrective reactions in a bull market. Wars, terrorism, politics, and social events in the main only affect markets indirectly. What ultimately moves stocks and therefore markets is the underlying value of the companies that those stocks represent. Only inasmuch as those non-market factors affect the underlying economics are they relevant. But the mass media would have you believe otherwise, because with daily air time to fill they report daily trivia.
  10. 10. 4 Bear Market Investing Strategies Economic trends are slow to build and slow to change directions, as are major bull or bear markets, which doesn’t make sexy TV talky talk. Chapter 3 describes past bear markets, as measured by the Dow Jones Industrial Average. The purpose is to create models of what past bear markets looked like, to be used as context when you construct your own view of possible future action. Chapter 4 lists economic and other general signs that suggest a bull market is ending and a bear market is beginning. Chapter 5 discusses foreign investment and whether one should put money abroad in a bear market. Chapter 6 discusses the difference between a bear market rally (secondary reaction) and the beginning of a new bull market. Chapter 7 is the mirror image of Chapter 6. It discusses down-legs in a bear market and how they differ from reactions in a bull market. Chapter 8 lists specific technical indicators that you can use for measuring both bull and bear markets (tools which act consistently in both bull and bear markets). Chapter 9 lists those technical indicators that behave very differently in bear markets to bull markets, so you need to decide which is occurring before you use these indicators. Chapter 10 discusses the usefulness of Cycles study. Cycles have their modest place in your toolbox of past models of markets, but the past never repeats exactly—as many cycles aficionados would have you believe. Chapter 11 teaches you about chart reading and chart interpretation. For most people, data in the form of a chart is more meaningful. ‘‘A picture speaks a thousand words.’’ Chapter 12 gives basic rules of investment in a bear market, when preserving capital is more important than risk taking. Chapter 13 teaches you all you ever wanted to know about short selling. Chapter 14 is perhaps the most important chapter in the book. No matter how savvy an investor you are, there will be times when you will be quite wrong about the direction of the market. This chapter gives you strategies to enable you to make money, even if you are wrong about market direction sometimes. Chapter 15 shows no matter whether you are a short-, medium- or long-term trader or investor, you really must develop a more flexible approach to buying and selling in a bear market than in boom times. Bear markets are a lot more volatile than bull markets, so they have to be watched more closely. Chapter 16 offers you some defensive investments that enable you to sleep nights, some of which you can hold long term. The trick is deciding what sort of bear market we are in, before you decide which defensive investments to choose. Chapters 17 and 18 discuss how human emotions, particularly your emotions affect your investment decisions.
  11. 11. Introduction 5 By the time you reach Chapter 19, if I have done my job well, you should already have a strong sense of where we might be headed, economically, in securities markets and on a social and governmental level over the next few years. Chapters 19 and 20 offer my personal overview of the next few years, to give you another context for your decision making. BE NOT AN OPTIMIST, NOR A PESSIMIST, BUT A REALIST The hardest part of developing a portfolio in a bear market is human nature’s natural optimism. There is a saying that man can live 30 days without food, 7 days without water, but only a few hours without hope. However much your intellect might believe that economic and technical factors point to a protracted bear market, your heart will inject the hope that the data is wrong. The hardest part of making money in a bear market is facing the fact that we are in one, and that, at least for a while, there will be few concrete signals that a critical turnaround is in sight. But, by the time you reach Chapter 20, you will know enough about bear markets to also know approximately how they end. BUY WHEN THE BLOOD IS RUNNING IN THE STREETS On July 8, 1932, the Dow hit a record low of 41, down 90% from its all-time high. It felt as if the disaster would never end. Yet, just a few weeks later, a new bull market began that, for those who bought, saw their investment more than quadruple over the next 5 years. In 1942, 4 months after the Japanese bombed Pearl Harbor, the Dow crashed to 92. The war loomed large into the future, and buying stocks was the last thing on most people’s minds. Yet those ‘‘realistic optimists’’ who bought, in the Spring of 1942, experienced a steady climb in values until the Dow hit 212 in 1946. In a sense, a bear is more of an optimist than a permanent bull. A permanent bull wants the past to continue forever, and, when it doesn’t, he becomes disoriented and/or depressed. But bulls who become bears when markets turn are bigger optimists because they know the downturn will not be permanent and after current problems a better future awaits, one where you can enjoy the fruits of your realistic investment strategies. They never forget that, in spite of setbacks, the history of human societies shows that the super long-term trend is up, and that even a huge bear market is only a multi-year setback in the grand scheme of things.
  12. 12. 6 Bear Market Investing Strategies If you can remind yourself daily that ‘‘this too will pass,’’ when most investors are still fearful of buying securities and economic data continue to be negative, but your composite picture of future market action indicates it is time to begin cautiously buying, then you will be buying at the beginning of the next great bull market.
  13. 13. Part I THE BEAR BACKGROUND [ ] ] [Quote not available in this electronic edition.] James Collins, quoted in The Internet Bubble, by Anthony B. Perkins and Michael C. Perkins, Harper Collins, 1999 (the 500 auto makers were reduced to 3)
  14. 14. 2 Overview ‘‘Every man takes the limits of his own field of vision for the limits of the world.’’ Arthur Schopenhauer, 1851 In the late 1950s, when I first started serious stock market investment/analysis, it was only necessary to put your assets into blue chips and watch them appreciate year after year. But, by the late 1960s and throughout the 1970s, the key to making money in markets was not just buying sound companies, but understanding Vietnam War-induced inflation, as government tried to supply both ‘‘guns and butter.’’ (Just as the US is doing today.) By the early 1970s, it was also necessary to have some understanding of foreign markets and international affairs, when OPEC, seeing their pound and dollar assets already eroding because of fiscal irresponsibility in both the US and Britain, temporarily cut off the West’s oil supply using the 1967 Arab– Israeli Six Day War as the excuse. And, as the value of the dollar declined, the value of the Swiss franc and the German mark rose sharply, so it was possible to make a great deal of money simply by moving out of US dollars and into Euro currencies and bonds. THE BEAR AND HIS MARKET Since this book is largely about bear markets, it seems necessary to give a dependable definition of both a bear and bear markets. A bear is an investor or trader who believes the trend of stock prices is down and trades or invests with that trend by selling his stock and/or selling short.
  15. 15. 10 Bear Market Investing Strategies A bear market is a depressed or declining market. One can have a bear market in real estate, advertising, automobiles, art, commodities, bonds, or anything else—including the stock market. A bear market in stocks is usually defined in ways that equate the mini-bear markets of 1983, 1987, and 1990 with the more prolonged bear markets we saw in the 1970s or even with the great bear market that began in 1929. I prefer to define bear markets in three categories: 1. Baby bears such as those we have seen during the last 20 years, which were little more than secondary reactions within a papa bull trend. 2. Mama bear markets such as we saw in 1973–74. 3. Papa bear markets such as the one from 1929 to 1942 and, in constant dollar terms, from 1966 to 1981. (See Constant Dollar Dow chart in Chapter 19.) Within these major bear markets, it is possible to have mini and medium size bull markets (more on this in the next chapter), but what makes them still a bear market, in spite of huge up-moves, is that the original damage to market and economic infrastructure is not solved until the end of the cycle. For example, it was not until the mini- bear of 1981 that the problem of inflation was solved, enabling the stock market and business to begin a major new bull market. During the last 20 years, many analysts have forgotten that, although when you buy or sell a stock you are at that moment simply making a bet with another investor on the future direction of that stock, you are not just buying a lottery ticket. You are buying a piece of a company. Therefore, it matters over the medium and longer term whether that company will succeed or fail. Today, it seems fashionable to divorce the value of a stock from its price. That was almost valid during the late great bubble, but may not be so again in our lifetime. New bubbles arise only when the last one is forgotten, usually in a new generation. BE NOT A BULL, NOR A BEAR, BUT A REALIST A bear is not (at least should not be) a permanent pessimist. Nor should a bull always be an optimist if he is wise. Both should try hard to be realists. You should be able to change from a bull to a bear or a bear to a bull, as conditions change, and not be the least inconsistent. Some people are permanent bears, and give the symbol a bad name. Permanent bears often have a puritan ideology that sees prosperity and bullishness as some kind of Original Sin. Likewise, many people are always bullish, obviously without sufficient justification. The almost continual bull market from 1982 to March 2000 has made most people permanent bulls. It has been impossible for them to accept
  16. 16. Overview 11 that any downturn is more than a short-term correction. But, in any market, the flexible realist is the winner—the man or woman who can switch directions overnight. So, let it be crystal clear that a proper bear is someone who used to be a bull but became a bear as conditions changed. SHORT SELLING—IT’S NOT UNPATRIOTIC Before going further, let me give a definition of short selling because it’s vital to what follows, and I don’t take up the subject in detail until much later. Short selling is the opposite of normal (long) stock positions. If you buy a stock hoping it will go up, you are ‘‘long’’ of the stock. But if you think the stock will go down, you can sell it first, and buy it anytime you please. This ‘‘short selling’’ is a simple borrowing-of-stock process that is handled by your broker with no need for you to understand how. Now, let me clear the air on another common fallacy that some people hold with regard to bears. Some think being a bear and/or selling short is in some way unpatriotic or negative. They believe that to invest your money in the industry of your country and lose it is more patriotic than to ‘‘sell those industries short’’ by selling their stock short—or simply selling out completely because you feel we have entered a bear market. Many TV market commentators, in the aftermath of the September 11, 2001 terrorist attack, urged investors to hold on to their stocks regardless of what the markets would do. At the beginning of G.W. Bush’s presidency, when he suggested that there were signs of weakness in the US economy, there was a cry of outrage from those who accused him of talking down the stock market and the economy—as if the health of our entire capitalist system is so fragile that it can be talked into changing directions. Even advisors claiming to help you recession-proof your portfolio cite people like Warren Buffet who made his fortune by buying and holding, regardless of short- and medium-term fluctuations. Most advise all non- professional investors to do the same, unless they are getting near retirement age, when switching into ‘‘bonds might be safer.’’ What these advisors fail to mention is that it is only since 1982 that buying and holding has paid off over the longer term. But Joseph Kennedy, father of JFK, for example, made his family’s fortune by short selling in the bear market that began in 1929. And many lesser known tycoons of the roaring twenties simply sold all their stocks and took a multi-year vacation, beginning around 1928. Nor did any of these men do the country or the stock market any harm. They stayed solvent and provided the capital for the next economic upturn.
  17. 17. 12 Bear Market Investing Strategies THE FACTS OF THE CASE If anyone is still not convinced, the facts are these: (1) If there was anything unethical, immoral, illegal, or un-American about it, the Securities and Exchange Commission wouldn’t allow it. (2) The country cannot benefit from having all its investing citizens lose money. Therefore, if some are able to make money in a declining market, this is all to the good. A free society needs solvent citizens, in order to remain free. One might also say it’s a patriotic duty to stay solvent. And, if short selling does that in a bear market, it can hardly be evil. You can’t help your family, country, or self if you lose your money. (3) Stock prices are merely people’s opinions of their value. And, since stocks once sold by the company are no longer the property of the company, the shorting of those shares is not shorting the company but rather shorting the opinion of the company as held by other investors or traders. Microsoft doesn’t get your money if you buy its shares, neither does it lose money if you sell its shares short and they drop in price and you make a profit thereby. You merely won a bet with a fellow investor. He thought they would go up. You thought not. You won. I’ll have more to say in defense of short selling in Chapter 13. It has been misunderstood for decades. (4) The short seller contributes mightily to the creation of more orderly and stabilized security markets through the demand for and the supply of securities he creates. In bull markets and bear, he is selling short, and he is eventually ‘‘covering’’ (i.e., buying), which demand puts a cushion under market declines. Without the short seller, our markets would be bottomless—those times when panic prevails and bulls rush for the exits while the short seller is calmly buying stock to cover his shorts and taking a profit. BEAR MARKETS ARE INEVITABLE It’s only reasonable to ask why we have bear markets. Many think we should have progressed far enough in social structure, in government guarantees, floors, and protection that we should have no more depressions, recessions, or bear markets. But to so think is to say we have changed human nature and repealed the law of supply and demand and stopped the pendulum that swings from surplus to insufficiency. Usually when government tries to manipulate prosperity, instead of allowing the business cycle to take its course, they make matters worse. For they destroy the price mechanism that lies at the heart of our free markets’ system.
  18. 18. Overview 13 It’s what Nobel Laureate F.A. Hayek refers to as the special information we all have that causes us to buy or sell at certain prices, but to regard products as too expensive or too cheap at others, which causes shortages or surpluses before the system adjusts. The business cycle simply reflects evolving markets. But, except in limited situations where liquidity is needed to prevent panic spreading, most govern- ment intervention is of little help and over the long term usually makes a situation worse. There are always ‘‘unintended consequences’’ to all govern- ment interference in an economy or market. For hundreds of years, people have been saying, at certain levels of the business cycle, that they were in a ‘‘new era of permanent prosperity.’’ Even in ancient Rome, they were under the impression they had a fixed state of affairs—an affluent society—as masters of the world. And, during the 1920s, so convinced was everybody that their new technology had ushered in a New Era that, just weeks before the 1929 crash began a decade-long depression, it was publicly stated that America had entered a permanent plateau of pros- perity. ‘‘The more things change, the more they remain the same.’’ No matter what a legislature does, no matter what a President, Prime Minister or Federal Reserve Chairman says, no matter what new concepts are around, the natural cycles of rise and fall take their toll—be it in stock markets, coffee prices, gold, land values, or whatever. GOING TO EXTREMES Simply put, a bear market in stocks comes about because the prices get too high in relation to their value. This is caused by public enthusiasm that gradually becomes excessive, appraising stocks out of proportion to their ‘‘true’’ earnings. It is the nature of such things to go to extremes in both directions. So, as a bull market often goes too high, so too does a bear market go too low. The excesses are caused by human emotions, about which we have more to say in the chapters on human psychology. THE FALSE PROPHETS One of the aspects of depressions, recessions, and bear markets that is most difficult to understand is the ‘‘false leadership’’ or false prophets that are prevalent during these times. In part, it’s intentionally false, as in the case of most political parties when in office. If they suspect (from government data) the business future is grim, they will rarely reveal this if they can avoid it. And
  19. 19. 14 Bear Market Investing Strategies what must be revealed to the public is distorted or delayed or colored. This is only human. Nobody wants to lose his or her job, and recessions and depres- sions usually cause politicians to lose the next election. The talking heads on television have a vested interest in talking markets up to maintain their station’s advertising revenue, and their jobs. Vested interest is knee-deep in the TV and mass media worlds. False prophets often speak with great sincerity when they say they foresee great prosperity ahead. Or if that statement seems less than realistic, then it’s a combination of wishful thinking and self-interest that cause them to announce we will have a ‘‘soft landing,’’ that we should be looking for new buying opportunities, that we’ve made a bottom. Most honestly can’t see around the corner. This is no crime. But if one wants to preserve his capital (and perhaps even dare to dream of increasing it) during a sick economy or market period, one must try to see around the corner. An important requirement for investment success is to think ‘‘contra.’’ If the Secretary of the Treasury in any nation says he looks for next year to be better than this year, one should form the habit of automatically being skeptical. It may be meant as a statement of fact, but the odds are that it isn’t. And by doubting it, you prepare yourself for preserving your capital. As Diogenes (325 BC) advises: ‘‘Be a cynic.’’ Likewise, in bad times, the chairman of some board may forecast that software sales will be rather miserable again next year. This should be greeted with the same reaction. It’s probably a time to buy shares in software companies. They may be right, but get into the habit of thinking they are wrong, because they probably are. The majority usually are. Even the majority of board chairmen, or Treasury Secretaries and Exchequers! The main focus of this book is help you to think your way to prosperity. I’ll offer some formulas, indicators, and strategies. But tools are of limited use if you don’t accompany them with logical, nonconformist, contrary thinking—an increasingly lost art in these days of computers and the Internet. Contrary to a computer? Yes, at times. WHAT CAUSES A DEPRESSION? Depressions or recessions are caused by basic economic changes of supply or demand or credit. What leaders say about circumstances cannot in itself help or hurt the situation, except perhaps for a few days. Talk just doesn’t matter. If an apple is rotten, the act of saying so will not make it ripe. If it’s ripe and someone calls it rotten, it will not turn rotten on the spot just because of this characterization.
  20. 20. Overview 15 RECOGNIZING THE BEAR The final section of this chapter must deal with the recognition of a bear market. How do you know when you are in one? While we will go into more detail in later chapters, one basic approach was defined by Charles H. Dow in a Wall Street Journal editorial of July 7, 1900. This premise still holds today. He called it: ‘‘The Great Law of Action and Reaction.’’ Today, it is generally known as ‘‘the 50% principle.’’ The sum of what Dow said so many years ago was: ‘‘It is a remarkable fact in speculation that both the average price of a number of stocks and the price of individual stocks show strong tendencies, both in rallies and relapses, to reach one half of all the primary movement. When a stock falls ten points in a comparatively direct move, it is extremely likely to rally as much as five points from the lowest. It often rallies or relapses more than half of the original swing, but it is generally safe to wait for about half. ‘‘A Comparison of the Averages . . . shows how regularly this movement occurs. When a recovery does not come near being one half of a decline, it generally means that the primary movement has not been completed and that a new low quotation will be made.’’ In Figure 2.1, we see the principle behind Dow’s words. If the left end of the beam (marked A) is forced up from its resting position, the beam will approach the horizontal position or 50% level (dotted position B). If the upward thrust has been great enough, the beam will swing all the way up to the high position (dotted position C). But if the upward thrust from A was insufficient, the beam may approach or touch the 50% level (B), falter, and then sink back to the original position at A. Figure 2.1
  21. 21. 16 Bear Market Investing Strategies TO SUM UP Thus we might draw these conclusions, based on Dow’s idea: 1. Following a major market advance, if, on the subsequent correction, the (Industrial) Average holds persistently above the halfway (50%) level, the odds favor the highs again being approached (or bettered). 2. Conversely, following a major advance, if the subsequent retracement or correction goes below the 50% level, the primary direction can be considered to have turned down. The preceding lows may then be approached (or passed). 3. Following a bear market, if a bull move succeeds in retracing 50% or more of the previous bear market decline, the odds then favor a new bull market’s approaching or bettering the old bull market high. 4. Following a bull market, if the next bear market succeeds in erasing more than 50% of the total bull market gains, the odds then favor the bear market’s testing the old bull market low. This principle applies in many fields, not just the stock market. If what I say in this book applied only to the stock market, it might be valueless because the market is made up of nothing more than people’s opinions. What they think and do makes prices move. So, to understand the market, we must also try to understand people and their motivations. We must also factor in social, political, and cultural aspects of human behavior when making a market decision. One must act contrary to the majority view—at the proper time and in the proper way. A CAUTION This book is necessarily written at one place in time, and looking ahead is still an inexact science, indeed an art more than a science. You, dear reader, must adjust your thinking as I will adjust mine, day by day, using the methods outlined in these pages.
  22. 22. 3 History of Bear Markets ‘‘To be ignorant of what occurred before you were born is to remain forever a child. For what is the worth of human life, unless it is woven into the life of our ancestors by the records of history?’’ Cicero, 46 BC THE USE AND ABUSE OF HISTORY History never repeats exactly. When we look to history for indicators of what the future might bring, we need to take a ‘‘little of this model and a little of that’’ in order to create a new composite model that is unlike anything that has happened before. This lesson has been forgotten after 20 years of an almost unbroken bull market. The possibility that we could get a protracted multi-year global bear market and recession is outside the comprehension of most investors. Most floor traders and fund managers today began their careers after 1980, so have no personal experience of the massive inflationary bear market of the 1970s. And when it began in 1966, many of them were not yet born. TECHNOLOGY FOSTERS LAZY THINKING Since the introduction of stock market software, it has become increasingly fashionable to compare today’s stock market patterns with past models, without taking into consideration that what created those particular patterns were not just market related but caused by cultural and political factors as well.
  23. 23. 18 Bear Market Investing Strategies Technology has made our lives infinitely more comfortable. But it is a double- edged sword. The more we rely on technology, the less we think for ourselves. And making informed judgments on the future of securities markets, based on an inner sense that comes from working with market data over many years, has become a lost art. Yet, there are so many factors that affect market behavior that cannot be reduced to a software package or a computer-generated predictive system. In this chapter, we list all bear markets for the last 100 years. But it is up to you, dear reader, to apply the models of history to current and future con- ditions, using not just market history, but the history of social, political, and economic events for the 20th century. An in-depth discussion of how these non-market historical events interacted with market action is outside the scope of this book. I therefore suggest you obtain a good year-by-year social history book of the last 100 years, to use in conjunction with this list of past bear markets. You’ll find it fun. TAKING A VIEW In Europe, where capital preservation is of a higher priority than a quick profit, they are in the habit of ‘‘taking a view.’’ While they may trade the intermediate and short-term swings of the market, they do it within the context of a multi-year concept of where the world in general economic terms is heading. This creates a difference between the two continents in how bear markets are defined. In America, all bear markets tend to be given equal ranking, with no consideration to the bigger picture. But that limited view is not particularly helpful for the longer term investor, particularly in today’s investment climate. I will elaborate on how ‘‘taking a view’’ applies to the next few years in Chapter 19. But, in this chapter on bear market history, let us concentrate only on the past. In the last 70 years, there have been two major occasions when taking a view enabled you to see a different, more accurate picture of events, than simply treating every uptrend in the market as a bull market, and every down-leg as a bear. These periods are 1929 to 1942, and from 1966 to 1982. Both periods were times when there were major economic and monetary problems that took well over a decade to resolve. Both periods were mirror images of what we have experienced between 1982 and 2000. On an economic and financial level, those 18 years have been a time of considerable growth. This gave rise to an almost continuous bull market. The mini-bear markets of 1987 and 1990 were almost exclusively Wall Street
  24. 24. History of Bear Markets 19 phenomena, in that little or no damage was done to the economic and financial health of the companies, which stocks represent. The major uptrend remained intact. But the long-term investor, who did not sell out before August 1987, found himself with major losses just 2 months later. And, by October, there was a lot of panic selling. But the investor who ‘‘took a view’’ would have known that October 1987 was not the time to sell. However, if that same long-term investor had looked at the underlying financial and economic structure in the late 1960s, he would have seen that not only was there a ‘‘bubble’’ mentality in electronics stocks, but that there were profound fiscal problems which were eating away at the economic health of American companies. This ultimately led to double-digit inflation. A new major bull market did not begin until the inflation was squeezed out of the economy. Between 1929 and 1932, the economy sustained tremendous economic damage. Even though the Dow rose 268% over the next 5 years, the damage caused to the economy and the dollar was not resolved until 1942. Thereafter, a sustained bull market began, which did not end until 1966. My point is that the simplistic conventional definitions of bear markets, that simply measure the extent of the drop in the various Averages in some sort of ratio to the time it takes for the drop to occur, are not very helpful to an investor deciding whether to unload his stocks at a loss, or hold on in hopes they will go back to their old highs. This doesn’t mean that one should have gotten out of stocks in early 1929 or 1966 and taken a holiday from the stock market for the next decade or so, although some people did. Instead, it means that when your ‘‘taking a view’’ indicators tell you that there are major economic and monetary problems that are likely to take a year or more to be resolved, you no longer can buy and hold, but should become a more watchful and flexible investor, playing the major upmoves, but doing so with one hand on the exit all the way up. I belabor this point because as of this writing, in early 2002, some analysts are predicting the beginning of a new bull market. I do not necessarily disagree with them. The Dow Jones Industrial Average or S&P Average could retrace much of their losses since 2000. If they do, they will do so with little regard for the global economic and monetary problems that began long before the September 11 attack, and will be there for some time to come. The cry of those proclaiming a new bull market is that the market generally leads the economy by 3–6 months. So, if we are in a new bull market, that must mean economic problems will be solved in 2002. That displays a faulty knowledge of history. The major bull market in the 1930s, and the two major bull markets during the 1970s, did not herald an end to the underlying monetary problems. Quite the reverse. In all cases, it was the lack of solution to the underlying health of the economy that pulled the markets back down.
  25. 25. 20 Bear Market Investing Strategies Why should we take a view and not treat all bear markets as equal? An example of this wrong thinking is the comparison of 1987 to the crash phase of 1929. Many people believe the Federal Reserve single-handedly prevented 1987 from becoming another 1929. Ergo, we now know enough to prevent another major bear market and depression of the 1930s magnitude. But if Fed intervention, which worked so well in 1987, is the way to prevent all future bear markets, why is it that since 2000, after more aggressive cutting of the discount rate by the Fed than at any time in history, there has been no 1987 style turnaround? 1987 AND 1929 COMPARED . After a 6-year bull market, beginning in 1923, the DJIA more than quadrupled, reaching an all-time high on September 3, 1929. The DJIA lost 40% during the next 55 days. In a selling climax on October 28 and 29, 1929, the DJIA lost 20% in just 2 days. . After sustained growth which began in 1984, the DJIA had almost tripled its low point of 3 years earlier. The Dow reached its peak of 2,722.42 on August 25, 1987. . The 1987 crash phase, as with 1929, began 55 days after the late summer high. . From peak to trough, the 1987 market lost 36.1% of its value, compared to 39.6% on the first leg in 1929. For somebody who did not ‘‘take a view’’ but looked only at the numbers, it appeared that 1929 and 1987 were similar bear markets. Those investors who, in 1987, believed they were seeing a rerun of 1929 came to two different and equally wrong conclusions. One group believed that 1987 was the beginning of a 1930s-style bear market, so missed out on much of the bull market which followed. The other group saw the Federal Reserve as a kind of latter-day Merlin, capable of creating permanent prosperity out of a potential 1929 situation. This latter group are still wondering why the recent, most aggressive rate cutting in history didn’t pull the same rabbit out of the hat that it did in 1987. As Mark Twain said: ‘‘There are lies, damn lies, and statistics.’’ The ability of computers to crunch numbers faster and better than ever before is a wonderful advance. But it has its drawbacks. The good side is that computers can process numbers and find connections that previously was impossible. The bad side is that ever more reliance on computers causes people to think ever less. And investing requires thinking. It is not a lazy man’s hobby.
  26. 26. History of Bear Markets 21 THE BEAR’S RECORD BOOK The first step to creating that composite model to see what the future may look like is to glance over past bear markets. You’ll find this of great help as reference material in the years to come (and especially for all the bear markets ahead). No single past model exactly applies to today. My list begins in 1900, because this was the first bear market after Dow created the DJIA in 1897. Panics and crashes from earlier times also have things they can teach us, but prior to 1897 market statistics are vague, so anything earlier can only be referred to in a general sense: 1900 DJIA declined 31.8%. Duration of bear market: 12 months. Crash came in December 1899. Bear market low in June 1900. 1903 DJIA declined 37.7%. Duration: 10 months. Crash occurred in November 1902. Bear market low in September 1903. 1907 DJIA declined 45.0%. Duration: 10 months. Had two crash phases, the first in February (DJIA fell 21.8% in this first phase); rallied in March and April. The second crash was July to November, a 4-month fall known historically as the ‘‘Panic of 1907.’’ A bull market started at once after the second crash. Stocks lost almost 50% (many much more) from the bull peak. A further fall was prohibited by the fact that business did not fall much further after the October economic collapse. Business coasted in a top area for 8 months after the start of the first market crash, then, suddenly and without an alarm, plunged down almost vertically in the midst of the second market crash. Business indicators hit bottom 3 months later, stayed there for 4 months, then began a healthy recovery: 1909 DJIA declined 26.2%. Started in November 1909, with the crash phase in February 1910. The bear market low came in July 1910. Duration: 8 months. 1912 DJIA declined 23.5%. Duration of bear market: 26 months. Crash came in June 1913, but bear had started in November 1912. Bear low came in December 1914. Since the stock market was closed for 4 months in 1914 by the war, a true picture of the decline here is impossible. One source says it was 36.3%. But I’ll take the more conservative published DJIA figures as my base. 1917 DJIA declined 40.1%. Duration of bear market: 13 months. Crash phase came in December 1916. Hit bear market low in December 1917. 1919 DJIA declined 46.6%. Duration: 21 months. Three crash phases. Initial crash November 1919 to February 1920 (DJIA fell 25% in this first
  27. 27. 22 Bear Market Investing Strategies phase). Second crash in late 1920. Final crash in summer of 1921. Hit low in June. Business topped out slowly during the first market crash, then coasted rather indecisively just below its top area for 6 months after the crash. Then it plunged sharply, right after Labor Day, 1920. A depression lasting 1 year followed. Business then recovered simultaneously with the stock market. The year 1921 was notable for a downswing that lasted 6 months nonstop, the second longest downswing in bear market history. 1923 DJIA declined 18.6%. Duration of this baby bear market: 7 months. 1926 DJIA declined 16.6%. Duration of baby bear market: 2 months. 1929 DJIA declined 90.0%. Duration 34 months. Six successive market crashes comprised this famed bear: (1) September to November 1929 (DJIA fell 40% in this first phase). (2) April to June 1930. (3) September to December 1930. (4) March to May 1931. (5) July to January 1932. (6) March to July 1932. A new bull market then started immediately, as did a business recovery. Business had topped out mildly, a month before the first crash; a gradual mild decline continued to April 1930, then fell sharply into a depression simul- taneously with the end of the 1930 stock market rally. The business decline halted in December 1930, stayed level for 6 months, then plunged again in steep economic decline that didn’t lose its downward momentum for a full year, until July 1932. Business improved intermittently thereafter but still remained at depression levels through most of the 1930s except for a short recovery in 1936–37. 1934 Rarely included among bear markets. But a fall of 24.1% in the DJIA gives it a deserved berth here. Duration: 9 months. Then the market took seven more months to get back up to where 1934 began. 1937 DJIA declined 51.8%. Duration: 56 months. Five crash phases: (1) August to November (DJIA fell 40% in this first phase). (2) February to March 1938. (3) January to April 1939. (4) May 1940. (5) October 1941 to April 1942. Business peaked out and fell violently, simul- taneously with stocks. Economic indicators bottomed out 9 months later (May 1938). The recovery began mildly at first, but was later boosted by the World War II production boom which eventually lifted the country out of the Great Depression of the 1930s. The period 1941–42 contained the longest bear market nonstop downswing (71 2 months) in history. Certain analysts call this two separate bear markets, one from September 1937 to March 1938, and the second from May 1940 to April 1942. If you are simply looking at market action this view may be correct. But
  28. 28. History of Bear Markets 23 if you take a wider view within the context of the depressed mood of the times, then it can be viewed as all part of a single bear market. 1946 DJIA declined 24.6%. Duration: 37 months. There was only one crash phase (August–September 1946), and the bottom was hit within 4 months. But the market moved sideways for almost three years and tested the 1946 low area three times. The final time was in 1949, after which the market rose almost without interruption for the next 12 years (160 to 741 in 1961). 1953 This was a very small bear market, but, as it was caused by war (Korea) uncertainty, I include it here. DJIA declined 13.9% (295 to 254). Duration of this quasi-bear market: 9 months. 1957 DJIA plummeted 106 points (522 to 416) for a 20.3% fall. Duration: 6 months. 1960 Opinions differ on whether this was a real bear market. But Dow Theory signals were given, so it is included here. DJIA declined 18.0%. Points lost: 124. Duration: 10 months. 1962 DJIA declined 29% in 6 months. Extent of 1962 damage: the first crash phase of 1929 lost 40 billion dollars. The 1962 crash lost over 100 billion dollars. Even if we adjust those values in terms of 1929 purchasing power, the 1962 crash still lost one and a quarter times as much as in 1929. 1966 Market plunged from 1001 to 735 in just over 8 months. This was the end of the postwar super-bull market. At this point, the whole atmos- phere of the stock market changed. A new factor entered the investor’s reasoning. Not only must he now assess the direction of the economy, he must also consider government monetary intervention, which might make him think he was making a profit, when in fact, in real value terms, he was not. We will discuss this at greater length in Chapter 19. 1968 This was a long, drawn-out bear market. The DJIA declined from a high in December 1968 of 994, down to a low of 627 in May 1970. This was the first of the new-era bear markets, caused not so much by a simple downturn in business but by currency woes. 1973 This one was scary! From a high of 1067 in January 1973, the market slid relentlessly down to its final low of 570 in December 1974. Its catalyst was the oil crisis. For the first time in American stock market history, a foreign power, or group of powers, were able to precipitate an economic slowdown. We had entered a new level of globalization after which the world would never be the same. 1977 DJIA fell fairly gradually, though gathering some momentum as it went from just over 1000 in January 1977 to a low of 736 in March 1978. Nothing dramatic caused it; rather more of the same of the past decade: increasing oil prices with dollar stability problems steadily worsening.
  29. 29. 24 Bear Market Investing Strategies 1981 This bear snuck up on people. DJIA made a rare quadruple top that convinced most investors it was building strength to break through. DJIA fell from 1025 in April 1981 to a low of 770 in August 1982, or 255 points. A mere 17-month-long bear, it led to a recession which was more severe than the stock market fall would indicate. 1984 Though this is not even considered a bear market by most, it scared a lot of investors because it broke below a giant support area and appeared to be heading back to the 1000 level, whence the bull market of late 1982 and all of 1983 had come. It fell 16%, from 1295 to 1080 in 7 months. 1987 This was a heart-stopper for the very reason that there was no apparent economic reason for it to occur. There were two catastrophic days of multi-hundred point drops, with one of those days being the largest one-day point drop in history. It came about because of computer programming (explained earlier), computer insurance schemes, and the globalization of markets. It was history’s first simultaneous global bear market where all major world markets were hit badly at the same time. Australia was among the hardest hit, Japan among the least, but all had considerable damage. DJIA fell from 2747 to 1616 (i.e., 36.1%), in less than 2 months. It took nearly 2 years to surpass its prior high. 1990 This was the direct result of Iraq invading Kuwait, and was halted when the US launched Desert Storm. DJIA declined 17%. Duration: 4 months. This bear market, along with that of 1987 are the shortest bear markets in history. 2000 By October 2001, the Nasdaq was down a whopping 72% though the DJIA was only down around 25%. But most worrying, well before the September 11, 2001 terrorist attack, was that the underlying economic health of the US and most world economies showed increasing signs of weakness. It is already clear that this bear market has damaged the broader economic health of all major economies, more than any other bear market in the last 60 years. But more of this later in our predictions chapter. BEAR MARKET FREQUENCY RATIO So, there you have the bear markets of the 20th century, and the first one of the 21st century. There has been a bear market every 4 years on average. The longest time span between bear markets has been the most recent bull market, which was 10 years if you regard 1990 as a major bear market; 20 years if you ‘‘take a view.’’ This is the powerful message, then, of this chapter: that even if you weight all bear markets as equal, and don’t think in terms of multi-decade papa bear
  30. 30. History of Bear Markets 25 markets within which mama and baby bull markets are possible, bear markets are frequent enough to make it impossible to ignore them, even in major boom times, or to avoid their losses. The decade of the 1990s was unique and, like the bear markets of 1987 and 1990, occurred because of a unique set of circumstances that are unlikely to repeat, let alone be considered a new paradigm for bull markets in the future— at least not in our lifetimes. Thus, the investor must try to understand bear markets better. Otherwise, the profits from the previous bull market are usually wiped out. AVERAGE PERCENTAGE OF VALUE LOSSES You have also seen that the percentage of decline in bear markets ranges from as little as 13.9% up to 90%. The total of all these percentage losses is phenomenal. The losses represented by all these declines are staggering, but when you realize that the blue-chip averages never fall as far as the great mass of small cap stocks, the damage to your wealth during a bear market can be more than most people can deal with. The averages mask a greater percentage fall by the majority of stocks not in the averages. Add to that the economic and fiscal damage that often accompanies a bear market. Say you lose your job, and that small stock portfolio was your ‘‘safety net.’’ Or you needed that extra money for the kid’s college fund, or an unexpected illness. You can be sure that the kid’s education or sickness in the family won’t only occur when your stocks have recovered any losses they might have suffered in the prior bear market. Unfortunately, during the 1990s, people came to regard investing in stocks as like putting their money in the bank, except that many were making 30% per year instead of bank interest of 5%. LENGTH OF BEAR MARKETS Bear markets have been as short as 2 months and as long as 5 years, the average being about 18 months. This current bear is already the longest in 60 years, which of itself suggests that although we may see what many analysts call a new bull market, it will more likely resemble those baby bulls of the 1930s and 1970s than the major bull market of the 1990s. Also, it should be noted that, in the 20th century, markets were in a bear phase for 341 months (i.e., 28 years of bear markets), and, in the last 90 years, we have been in bear markets 35% of the time. If that statistic doesn’t change your belief in a buy and hold investment strategy, nothing will.
  31. 31. 26 Bear Market Investing Strategies Clearly, this makes the stock market a dangerous place—with a pitfall hidden under every third stepping stone. Not only does it mean the permanently bullish investor only has two chances in three at best, but when you consider that the depressed psychological climate at bear market bottoms prevents the majority from investing at the best time, it means that, by the time the majority of investors recognize a bull market is present, it is half-gone. But by showing you how to face bear markets with confidence, and make money in them, I hope that, by the end of this book, you will be among the first people to invest in the next great bull market. TRUE RISKS ARE STAGGERING The situation is made worse by the fact that the average investor (90% of investors) can’t be expected to spot the exact top of bull markets and sell out in time. This means he loses much of the prior rise before he does sell. A professional man, a physician, who throughout the late 1990s prided himself on his ability to trade online, admitted to me a few months ago that: ‘‘I haven’t sold anything because what would I do with the money?’’ Then, a month after the September 11 attack, he remarked that it was only on October 1 (i.e., 3 weeks after the attack) that he had the courage to switch on his computer to check the prices of his stocks! His reactions, which I am sure were echoed by millions of investors across America, surely explode the myth that you can just invest and sit and wait. Everybody needs a plan, one that includes strategies for selling as well as buying—and (once understood) for selling short when that seems to be the prudent course of action. Without a plan of action, when the unexpected occurs, when markets suddenly fall, or terrorist attacks strike, that is not the time to think up an investment strategy. It is a time to act on realistic strategies for both bull and bear markets that you had already decided upon, when you were feeling less stressed. PERIOD OF READJUSTMENT For those who still believe that if they hold on they will do better than if they sell at a loss, let me reveal another statistic. After each of the 21 bear markets prior to 1987, prices did not immediately zoom back to new high ground. This ‘‘V’’ bottom, that analysts always tell you they are expecting shortly, has absolutely no history in prior bear markets that have gone on over 18 months, as this one has. Most of those 21 bear markets took many months or even years to get back to where they were before the fall.
  32. 32. History of Bear Markets 27 After the 1929 bear, it took 26 years to recover. If that is too extreme or too much like ancient history to you, it took 14 years after the 1937 crash, and the 1966 peak of 995.15 was not decisively breached on the upside until 1982 (i.e., 16 years later). And, along the way, there were some pretty wild swings to the downside including the 1974 low when the DJIA lost nearly 50% of its value, and in ever more inflated (depreciating) dollars. So to buy and hold, you not only need lots of patience, lots of spare cash (so you won’t need to draw on your investments to pay bills), but you also need nerves of steel to sit through the decline. LEARNING FROM THE PAST ‘‘I saw a new heaven and a new earth . . . and the former things were unremembered.’’ This seems to be true of every age. In 1929, they had had seven prior bear markets, just since 1900, on which to build their knowledge. But it was to no avail. People, by nature, almost defy learning from the past. They contend that having had depressions, man acts to prevent their recurrence. But the evidence doesn’t support this. Militaries usually focus on better ways to fight the last war, that’s why when terrorists used a passenger plane as a megaton bomb, not only was the military totally unprepared to deal with such an attack, but Intelligence (which is supposed to find out about these things before they happen) had no idea such an attack was imminent. Both military and Intelligence were focused on ` possible terrorist use of smart bombs a la the Gulf War, or nuclear devices. So too with many economists and market analysts, who compile the data from past bear markets, and then search current market conditions for an exact match with past models. Any future bear market will be sufficiently unique and there will be sufficient ‘‘proof ’’ that this bear does not fit any prior model, to enable people to deny that it is happening all the way into bankruptcy. CONCLUSION If a conclusion is possible, it is probably that the only way to avoid odds that are little different from red and black in roulette, is to play both sides of the wheel (i.e., be willing to hold stocks long or short (or both) as circumstances warrant). You should have contingency plans in place if markets don’t act as you expected, and use what economists call ‘‘unarticulated knowledge,’’ but
  33. 33. 28 Bear Market Investing Strategies which the rest of us call intuition: that inner judgment that takes into account social, political, and cultural conditions, often without bringing it to your conscious attention except in the form of an uneasy feeling. Be flexible and trust your instincts.
  34. 34. Part II ECONOMIC SETTING FOR BEAR MARKETS ‘‘Ultimately, in a free society, we cannot protect people from all the consequences of their own errors. We cannot protect people completely without denying them the possibility of achieving their own fulfillment. We cannot completely protect society from the effects of waves of irrational exuberance or irrational pessimism—emotional reactions that are themselves part of the human condition.’’ Irrational Exuberance, by Robert J. Shiller, Princeton University Press, 2000
  35. 35. 4 Guideposts for Bear Markets ‘‘It requires a great deal of boldness and a great deal of caution to make a great fortune, and when you have got it, it requires ten times as much wit to keep it.’’ Ralph Waldo Emerson (1803–82) Lists of data abound, showing signs to look for to tip you off as to whether we’re heading for business improvement or slump, or for a bull or bear market. During the latter part of the 1990s, these data was used selectively by financial commentators. Analysts fought to get air time or print space for self-serving reasons. And Wall Street became part of the entertainment industry. Thoughtful judgment calls, based on extensive research, were no longer expected of TV or print media analysts. Instead, they were and are expected to entertain viewers and readers, and to put a positive spin on all economic and financial data, no matter how dire it is in reality. Market terminology is being twisted into the new language of Street-Speak, where nothing is ever what it seems, and the need for news has disappeared in favor of the need to be reassured that, no matter what happens, the bull market will resume next week or next month. Symbols have taken over from substance. And after years of the Clinton- induced culture of ‘‘feeling your pain,’’ a major reaction in the US to the September 11, 2001 attack was to go out and buy a flag and wallow in the emotions of grief, instead of learning about crisis management for their port- folios, responsible citizenship, and for their daily lives. My first book in 1964 was also on bear markets. In it, I published a list of ‘‘bear market signs’’ for the responsible investor to watch, to alert them when a bear market was imminent. Though many of those signs are still valid for a
  36. 36. 32 Bear Market Investing Strategies medium and long-term investor, and I will get to them in a moment, the way many of them now operate has changed drastically in the last 5 years. Until about 1995, technical indicators usually had a few weeks lag time before the data manifested themselves in the markets. And the connection between economic conditions and stock market direction was still accepted as fact. But, from about 1995 on, the media and governments have manipulated all data so much that the average investor today believes that, provided the Federal Reserve and US government cut interest rates or create bail-out packages, it won’t be long before the late great bull market of the 1990s resumes. Even the language has changed. In the 1980s, when it was necessary to subsidize the Savings and Loan industry to prevent it from collapsing, it was called a ‘‘bail-out.’’ And, though it did not cause a full-blown bear market, it was considered bearish enough to create a sizable correction in the DJIA. In late 2001, with the airline industry on the verge of collapse and production at new lows, the bail-out was called ‘‘an economic stimulus package,’’ and investors’ reaction to the news has been to push the market back up! In the past, increased government spending and, at the same time, massive increases in the money supply were regarded as fiscally irresponsible and a harbinger of inflation. Today, investors turn to government with the same naive gratitude a small boy might show a parent who replaced the pocket money he lost. The media has created a culture of victim investors: when the news is negative but not ‘‘our fault.’’ The media admits there are problems but blame it on terrorists or whoever. But when the news is positive it is the government who claims the credit for creating that success. This causes far more volatility in markets than ever before because, when the only factors admitted to be causing a business turndown are claimed to come from outside, markets seem totally unpredictable and people will panic more. But none of this has changed the laws of economics, or stock markets. And companies ‘‘patriotically’’ and foolishly buying back their own stock or investors watching their retirement accounts diminish while they wave the flag won’t change long-term trends, nor do a thing to solve the very real problems that the economy had long before September 11, 2001. During the near vertical fall in 1930, John D. Rockefeller consumed a considerable portion of his enormous fortune buying back his stock in Standard Oil, then a DJIA company. He managed to stall the market fall for a few days. But he was no more able to reverse the laws of economics than today’s ‘‘patriotic’’ investors can. What has been totally forgotten in the last several years is that when Charles Dow created his Average, he saw it, not as a stock market indicator, but as an indicator of economic health. He understood that stocks are no better or worse than the companies they represent. It is the economy that drives the stock
  37. 37. Guideposts for Bear Markets 33 market, not the other way round. Yet today, the only time commentators admit the connection between the price of stocks and the companies they represent is when there is a technical rally in stocks, and they remind us that stocks rise before a recession is ended. Ergo, if stocks rise, the economic recovery must be just a few weeks away. SIGNS A BULL MARKET IS ENDING No matter what Washington or the media claim, bull markets cannot be sustained if the economy is faltering. Neither can a bear market suddenly become a new bull market, with a ‘‘V’’ bottom (media-speak) while economic indicators are getting weaker: 1. The most important indicator that a downturn still has a long way to go is when investor sentiment is still bullish while the underlying economic structure continues to weaken. 2. Price earnings ratios. In recent years, even rational analysts have puzzled over why they no longer seem to ‘‘work.’’ This is all part of the separation of stocks from the values of the companies they represent. In his book Irrational Exuberance, Yale professor Robert Shiller points out that, since 1870, price earnings ratios for big companies have averaged just under 13 for a yield of 7.75%. In late 2001, that ratio was between 25 and 35, for a yield of about 2–4%, depending which biased source you read. To return to a more trad- itional price earnings ratio, the DJIA would have to fall to at least 5000. I will discuss that in more detail in a later chapter, but suffice it to say here that it suggests that this bear market has further to fall. 3. The Federal Reserve. Fed action has been the most closely watched indicator in the last 5 years. But, with the most aggressive rate reduc- tions in history, driving US interest rates down to a level not seen since the 1960s and with no result, it is increasingly clear that when the US economy goes south, there is little government can do to stop it. 4. Consumer and Investor Confidence. There is always an abundance of confidence in the future of business and the market, at peaks. Even after markets turn down, as long as that confidence remains high the bear market has further to go. Markets traditionally turn around on low volume in the middle of widespread gloom about the future. Those who buy at the very beginning of major bull markets or sell at the beginning of bear markets are regarded as equally unhinged, as I was regarded in the Spring of 2000 when I suggested, in my newsletter, the Nasdaq was a sell.
  38. 38. 34 Bear Market Investing Strategies 5. Gold. In times of uncertainty, the interest in gold and gold shares picks up. 6. Real Estate. It is normal for real estate prices to rise with stock market prices. There is usually a lot of public speculation in real estate at bull market tops. Whether real estate turns down in a bear market depends on how much inflation there is. In inflationary bear markets, real estate is seen as a haven and prices rise. In bear markets where inflation is low and the currency firm, real estate prices will usually stay firm in the early stages, but will decline as the bear market deepens. 7. Stock market action. At tops, there is what is commonly classified as ‘‘churning’’ (i.e., high volume but not much change in prices, or great irregularity in prices [some up sharply, some down sharply], plus a lot of volatility day to day). 8. Unanimity of bullish forecasts. Business leaders, brokers, advisory services, columnists and broadcasters are, in the main, bullish. Any downturn is dismissed as temporary. 9. Sharp rise in debt. At the top of a bull market, the pervasive mood is that one can make a profit in markets, without risk. Consumer debt, household debt service payments, losses by credit card issuers, bank- ruptcy filings and mortgage delinquencies all rise sharply. This list is not complete and, with government playing an ever bigger role in our financial and economic lives, this list changes constantly. But I offer this list to stimulate your own thinking, as an antidote to the pap coming from the media and government trying to convince you that if you just buy and hold, consume like crazy, and put your trust in government, the economy will roll as it did in the 1990s. I encourage you to be ever mindful of how free markets work, and that the basis of prosperity is responsible citizens willing to assume risk, who never lose sight of the fact that all monetary decisions involve risk. Our system relies on solvent citizens who are self-reliant, not on government’s ability to manipulate interest rates or create ‘‘stimulus packages.’’ FADS AS A LEADING INDICATOR FOR THE END OF A BULL MARKET All major bull markets of the last 100 years were fueled by new technology. But, in most instances, the genuine advances that the technology created were exaggerated into what became an almost religious belief in technology for its own sake. New Eras and New Economies became fads. Toward the end of bull markets, fads increase and give us a hint of our nearness to the next bear market. Both fads and new technological advances
  39. 39. Guideposts for Bear Markets 35 look much the same on the surface. Experience brings the ability to tell the difference between ‘‘the sizzle and the steak.’’ Thus, in the 17th century, when the big tulip craze hit, a savvy investor with a modicum of common sense should have suspected that, however full of limitless possibilities the new globalization that enabled the Dutch to enjoy this exotic flower was, a single tulip bulb could not possibly be worth the price of an Amsterdam house. But hundreds of experienced investors bought tulips as symbols of the new shipping technology, rather than buying tulips on their own merits. They bought into a fad. So it was in the 1920 Florida land craze. There was nothing wrong with either Holland’s tulips or Florida’s land. But one needs to look at them as business propositions, instead of getting caught up in an abstract idea. Investment trusts (we call them Mutual Funds now) were a fad before the 1929 crash. In the late 1960s, it was electronics companies, many of which by 1970 had lost 80% of their earlier value, and some had gone out of business entirely. We saw a similar fad in the late 1990s in the form of dot.coms. Both electronics and the Internet have been magnificent technological advances, and we will enjoy their benefits for years to come. But they became fads because they represented such spectacular advances that investors ignored such mundane considerations of whether the companies using the technology were viable businesses. Fads are a major indicator that a bull market is reaching a bubble stage. SIGNS A BEAR MARKET IS ENDING 1. Bad news abundant. The stock market always seems to start up before the bad news (about lower industrial production, unemployment, lack of consumer confidence, etc.) stops. At that point, the market will be acting ‘‘contrary to the obvious,’’ which is usually a good sign that the market is right in whatever it does. 2. Credit. Still tight. But credit balances in brokerage accounts usually are considerable. Large holdings in bonds and other cash-related invest- ments. This latent buying power is what will give a new bull market its stamina. 3. Stock Market. Volume low, not much interest. Stocks selling at low price earnings ratios, high yields. But then new lows in the DJIA and S&P occur on even lower volumes. Some key stocks begin to show good rally potential. Volume tends to increase on rallies, decrease on dips. Charts are the way to spot this. 4. Confidence. Nil. Pessimistic forecasts made for the market and for business.
  40. 40. 36 Bear Market Investing Strategies 5. Real Estate. Unless it has been an inflationary bear market, real estate prices will be down. It is hard to sell property. Lots of empty commer- cial buildings. Rents reduced. Foreclosures rise. 6. Bonds. Government bond buying is popular. Corporate bonds are high, yields low. THREE BEAR PHASES It may shed further light here to quote from Robert Rhea, who was a hugely successful investment advisor during the 1930s. I will quote a number of market researchers from the 1930s and 1940s in this book because they saw things a lot more clearly than many do today. Government and media spin was not in vogue, then. Today, in our highly complex world, we tend to lose sight of the forest because we are too busy avoiding the trees and the undergrowth. Writers from a simpler time had the luxury of being able to see the big picture with less distractions from ‘‘clutter.’’ Today, TV sound bites appeal and deceive simultaneously. Said Rhea: ‘‘Bear markets seem to be divided into three phases: the first being the abandonment of hopes upon which the uprush of the preceding bull market was predicated; the second being the reflection of the decreased earning power and reduction of dividends; and the third representing distress liquidation of securities which must be sold to meet living expenses. Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market.’’ WATCH YOUR EMOTIONS Logan Pearsal Smith, in 1931, said: ‘‘Solvency is entirely a matter of tempera- ment and not of income.’’ My greatest caution in this entire signs-of-the-times section is to urge that you hold a strong rein on yourself, otherwise your emotions or prejudices of the moment (be they bullish or bearish) will cause you to read the total situation as bullish or bearish on the basis of selective evidence. Or, you will be too demanding and expect too many signs of the times to be convinced the climate has changed.
  41. 41. Guideposts for Bear Markets 37 BE FIRST The great advantage of being aware of these potential signs of coming events is that, when you read or hear data of the changing economy, you are able to interpret it immediately and, if necessary, act on it. You know what to look for and you recognize it before it is fully reflected in stock market prices. If the signs of the times were easily interpreted, the future would be plain for all to see. They aren’t, and it isn’t. Don’t expect to see too many signs occur at once. They show up over a period of perhaps many months, as the giant economy slowly rolls over, or yawns and slowly comes back to life. In this respect, we see again that the stock market is non-accommodating. It isn’t going to conveniently flash all its red or green lights at once so everyone can see at a glance what direction is next. Remember the old Wall Street adage: ‘‘Don’t confuse brains with a bull market.’’ And don’t imagine that markets turn on dimes and change direction overnight, as the mass media would have you believe. BUSINESS INDICATORS Many of the ‘‘signs’’ given earlier in this chapter are business indicators. But the lists are by no means complete. I encourage you to add new signs to your personal list, things which you feel offer keys to a change in market direction. Many accepted leading indicators are lagging or coincident indicators, so, if you want to stay ahead of the crowd, you need take note of those indicators as soon as the facts are known. The best way to use these indicators is not to create some mathematical model on your computer (though that’s OK as a reminder and checklist) but to develop an internal model in your head. Ideally, make lists of the facts as soon as you know them, with a note of what they will do to what economic indicator and when that indicator will be released, and then forget about it. Slowly, a pattern will emerge without you being conscious of it. Suddenly, you will find yourself muttering ‘‘meaningless’’ when somebody tries to point out the significance of a minor rise in retail sales, or a fall in commodity prices, because of the overall ‘‘index’’ you keep in your head. To separate wheat from chaff is a vital function amid the signs of the times. It is a fact that no two bear or bull markets are exactly the same in their manifestations. This is why a single investment software package is of limited use. Software, unlike the human mind, can only compare present models to those in the past, usually almost exactly. And, though we may have a future bear market as inflationary as those in the 1970s, or as economically devastat- ing as the 1930s, or any in-between, the only certainty is that any future bear
  42. 42. 38 Bear Market Investing Strategies market will not look exactly like any in the past, though it will doubtless have elements of past markets. However, software that records and keeps technical indicators for you can be of tremendous value, and saves you the tedium of having to calculate the indicators on a daily or weekly basis. The type of lateral thinking needed to use the past to construct a plausible future is something that only a human mind can do, and for the foreseeable future no computer can. THE EFFECTS OF GLOBALIZATION Today, the world is so interconnected that the economic problems of any nation spills over to every other nation. Everybody exports to everybody else, so when one economy contracts, all those who do business with the problem economy are affected. You may have no interest in investing outside your own country. But you cannot afford to ignore what is happening in other countries. Economic problems abroad can be a leading indicator of possible problems at home. Even if you never plan to invest in another country, I urge US readers to watch European news on television, and take a subscription to the Financial Times and The Economist. European media give international coverage of the sort that US media do not. Likewise, non-US readers should read the New York Herald Tribune and/or the Wall Street Journal for a US insight. THE HOUSE OF CARDS EFFECT In our interdependent world, it’s a house of cards no matter how you stack it. We stand together or fall together. For those still not convinced, let me offer an example. Envisage a major city with several thousand businesses. In a depression, can you imagine that the depression would affect only half of them? Would you expect to find 1,000 prospering as never before while the rest were losing business? Or is it more logical that all would feel the pinch, in varying degrees, of the national slowdown in business? Today, the global economy functions much like a major city. ‘‘Pockets of prosperity’’ amidst adversity, be they cities, neighborhoods or entire nations, have become rare.
  43. 43. 5 Globalization, Terrorism, and Foreign Investment ‘‘A traveler without knowledge is a bird without wings.’’ Sa’di, Gulistan (1258) In the last 20 years, a number of foreign funds came into being, and conven- tional wisdom was that a portion of a well-diversified portfolio should be invested in other countries. Has terrorism changed this idea? Will the world now revert to a 1930s’ mentality of barriers against trade? Answer: globalization is too far advanced to be reversed by terrorism. Europe has lived with terrorism for over 40 years without it unduly affecting their securities and bond markets. It is likely that Wall Street will be the same. Though events like September 11, 2001 directly affect markets over the short term, what moves markets over the medium and long term are the underlying economics. Those economics may indeed be affected by political actions, ideol- ogies, or acts of terrorism and war. But these non-economic factors will only modify or amplify economic trends already in progress. They will not, unless they are exceptionally severe, reverse them. During the late great bull market, many American analysts suggested that a well-diversified portfolio should be as much as 50% in foreign investments and 50% in American securities. In today’s highly unstable world, 40–60% would be wiser. There are some foreign investments that come into their own in bear markets. And, in some kinds of bear market, you can make more money investing abroad than you can make investing domestically.
  44. 44. 40 Bear Market Investing Strategies But you should take very seriously the quote at the start of this chapter. If you have little knowledge of a country, study their market charts. Charts are knowledge. Buying and selling foreign stock directly is a bit complicated until you get familiar with the way the issuing country operates. You can check if the shares are available via American Depository Receipts (ADRs). Or use a country fund (e.g., all Japan shares, or all Europe, etc.). ADRs An American Depository Receipt is a receipt for shares of a foreign company, deposited in an American bank. Once the initial transaction has been made, a bank issues the ADR, and thereafter those foreign shares trade in much the same way as any American shares do. ADRs are traded only in the US and not on the exchange of the country in which the shares are issued. For this reason, although the price of an ADR closely follows that of the stock it represents in its country of origin, there is sometimes a fraction of a point difference between the two, which very sophisticated traders use for arbitrage. Only major non-US companies are available in the form of ADRs. But for the average bear market investor who wants to buy non-US gold mining shares, or shares in any major foreign corporation, ADRs are a handy way to do so. GOLD MINING SHARES Some of the best gold mining companies are not American, but Canadian, Australian, or South African. In times of instability, gold mining companies tend to rise ahead of gold bullion, so gold mining shares are often a more attractive buy in the early stages of a bear market, particularly an inflationary bear market. Most major foreign gold mining companies have ADRs. CURRENCY PLAYS Another reason to invest abroad during a bear market is if you fear inflation will erode the value of your own currency. The late 1970s was such a time. If you simply want to put money abroad in a foreign currency at interest, the easiest way to do that is via a Swiss or Dutch bank. Swiss and Dutch banks are more internationally minded than most and cater to English-speaking foreign investors. They can set you up with time deposits or bonds for any major
  45. 45. Globalization, Terrorism, and Foreign Investment 41 currency in the world. How do you open a foreign bank account? Answer: in exactly the same way you open a local account. You either mail your bank of choice a check with instructions to open an account for you, or you make a direct bank transfer. Some major Swiss banks require a minimum deposit in at least six figures, and a few private banks require at least a million dollars. So, check out the bank of your choice before you decide to open an account with them. But the majority will take a minimum $25,000 deposit. There are US branches of many major foreign banks where you can open your account in person. But, if you seek privacy, avoid them and deal direct. In any future inflationary bear market of the kind we saw during the 1970s then a Dutch or Swiss bank account would be a good investment move. Will inflation get as bad as it did in the 1970s in the foreseeable future? You will have to wait till Chapter 19 to find out! You can also trade currency futures on the International Monetary Market (IMM) in Chicago. Futures of any kind are for nimble traders. But it’s a skill like all others. It also demands time to monitor, more so than stocks or bonds. Margin requirements for futures are much lower than for stocks, so when you buy a future (in anything, not just a currency future), you are much more leveraged than when you buy a stock, even if you buy a stock on margin. This means if you are correct on the direction of a particular currency, then your profits are multiplied because of the leverage. But if you are wrong, you can lose dramatically. And because bear markets tend to be more volatile than bull markets, currency futures are not considered by many a bear market trading vehicle, even if your domestic currency is inflated. The leverage factor, plus the fact that all markets, including currency markets, are more volatile in bear times than in bull, make futures seem risky. But if you obey disciplines and use stop loss orders, they are useful. Yet, for the majority, it’s easier to open a foreign bank account, with a time deposit, if you want to hedge your own currency, than to trade currencies in the futures market. GLOBAL INVESTING IN MAJOR BEAR MARKETS Terrorism will dampen global investing somewhat, but will not eliminate it. Even if terrorism did not exist, the natural tendency of most investors is to seek higher risk during a bull market than in a bear. Unless domestic inflation becomes a major issue, as it was during the 1970s in both the US and Europe, during a bear market, less people are willing to invest globally, either directly or via a mutual fund. In addition, if a bear market bites hard, multinational companies will need to cut back. The first places they are likely to cut are the last places they invested in. It is likely that some multinationals will become less global in their reach over the next few years, for practical economic reasons. The international
  46. 46. 42 Bear Market Investing Strategies markets for new technology have, in the main, reached saturation point, even though there are, for example, billions of Chinese and Indians without computers. But high tech needs a basic infrastructure which many non- industrialized nations do not yet have. Until that infrastructure is created, there are, in many cases, not even the roads to truck the computers to consumers, let alone electrical outlets to plug them into. A bear market is a time when companies regroup and consolidate rather than build new plants and try to nurture new business in foreign countries. And in this interconnected world, as America goes into a recession, most of the rest of the world follows. In any future major bear market, with the exception of gold mining shares, there will probably be fewer foreign companies worth investing in, just as in the US. As with multinational companies, a bear market is a time for the average investor to regroup and concentrate more on preserving capital, than taking risks in bull markets.
  47. 47. Part III STRUCTURE OF BEAR MARKETS ‘‘Many a healthy reaction has proved fatal.’’ Humphrey Neill
  48. 48. 6 Secondary Reactions ‘‘One of the greatest pieces of economic wisdom is to know what you do not know.’’ J.K. Galbraith In bear markets, we must turn our thinking upside down in many respects. For example, a ‘‘reaction’’ is now an up-move, because it is against the main trend. Every leg-down in a bear market is interrupted by a secondary reaction, which may come in two or three phases. These reactions are lifesavers for those who failed to take action when the bull market ended and are now stuck with giant losses. The secondary reaction gives us a chance to ‘‘bail out’’ at higher prices. It also gives an opportunity for shorting. Failure to sell out on this rally means you risk ‘‘taking a bath’’ when the next leg of the bear market comes into play at the end of the secondary reaction. Of course, the possibility is ever present in any bear market that the rally will turn out to be a primary reversal. To distinguish between a true secondary and a primary reversal, I can probably do no better than to turn to the words of William Peter Hamilton, the successor of Charles Dow, who developed Dow’s ideas into the Dow Theory we know today, and Robert Rhea, who further refined Dow Theory during the 1930s. DECEPTIVE RALLIES ‘‘An understanding of a secondary reaction,’’ wrote Robert Rhea, ‘‘is needed by traders to about the same extent as a growing cotton crop requires